Long-term contracts and entry deterrence in the French electricity market - Motivated by recent EU case law, we investigate how long-term contracts may be used as a means of entry deterrence in the French electricity market.

1. Long-­‐term
contracts
and
entry
deterrence
in
the
French
electricity
market
Author:
REID,
Christopher
Supervisor:
SPECTOR,
David
Referee:
TROPEANO,
Jean-­‐Philippe

2. Motivation
• March
2010:
decision
by
the
EC
in
EDF
long-­‐term
contracts
case
• EDF
sCll
dominant
on
electricity
market:
• large
market
share
• barriers
to
entry:
resale,
regulatory
framework,
informaFon
on
customers
• size
of
client
porIolio
• verFcal
integraFon
(variety
of
means
of
producFon)
• Foreclosure
of
market
through
supply
contracts:
• volumes
• duraFon
• nature
of
contracts
• EDF
commitments
made
legally
binding
by
EC:
• 65%
of
electricity
supplied
to
large
industrial
consumers
returns
to
the
market
each
year
• Limit
duraFon
of
contracts
without
free
opt-­‐out
to
5
years
• Allow
compeFFon
during
contract
period

3. Literature
review
• In
the
mid
20th
century
there
were
several
cases
in
which
the
U.S.
judges
found
exclusionary
contracts
to
be
anFcompeFFve
and
illegal
• Chicago
School
response:
compensaFon
for
lost
customer
surplus
exceeds
monopoly
profits
à
exclusionary
contracts
not
profitable
(Director
and
Levi,
1956)
• Aghion
and
Bolton
(1987):
buyers
sign
exclusionary
agreement
despite
jointly
preferring
to
refuse
à
contracts
may
be
used
profitably
• Relies
on
economies
of
scale,
liquidated
damages,
and
condiFonal
offers
• Rasmussen,
Ramseyer,
and
Wiley
(1991):
incumbent
may
exclude
rivals
by
exploiFng
buyers’
lack
of
coordinaFon
• Does
not
require
previous
assumpFons
• Financial
forward
contracts:
entry
deterrence
effect
depends
on
mode
of
compeFFon
• Allaz
and
Vila
(1987):
Cournot
compeFFon
à
compeFFon
is
increased
• Mahenc
and
Salanié
(2003):
Betrand
compeFFon
à
compeFFon
is
reduced

4. French
electricity
market
• Very
large
share
of
electricity
produced
from
nuclear
power:
• 75%
of
total
producFon
• 60%
of
installed
capacity
• Compared
to
fossil
fuels,
nuclear
power
has:
• Low
operaCng
costs
à
mostly
provides
base
demand
• High
capital
costs
à
makes
entry
difficult
• Our
model
of
the
French
electricity
market
has
two
segments:
• ConvenConal:
infinite
capacity,
marginal
cost
P
• Nuclear:
capacity
K,
marginal
cost
c
<
P,
investment
cost
b
• We
focus
on
compeCCon
in
the
nuclear
segment
• the
convenFonal
segment
is
considered
perfectly
compeFFve

5. Monopoly
• We
begin
by
calculaFng
the
nuclear
capacity
K*
such
that:
• Total
welfare
is
maximised
• Monopoly
profit
is
maximised
• Total
welfare
=
consumer
welfare
+
total
profit
=
indirect
uClity
-­‐
total
cost
• Prices
are
just
a
transfer
between
consumers
and
firms
• Demand
is
perfectly
inelasCc,
so
maximizing
total
welfare
is
equivalent
to
minimizing
total
cost
• First,
we
need
to
determine
the
distribuFon
of
demand

6. Electricity
demand
–
yearly
pattern
0
10
20
30
40
50
60
70
80
90
100
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Average
electricity
demand
(GW)
Date
Daily
MA(7)

7. Electricity
demand
–
daily
pattern
0
10
20
30
40
50
60
70
80
90
100
Weekday
electricity
demand
(GW)
Time
of
day
Mean
5%
95%

8. Electricity
demand
-­‐
distribution
0.000
0.005
0.010
0.015
0.020
0.025
0.030
0.035
0.040
20
30
40
50
60
70
80
90
100
110
Electricity
demand
(GW)
kernel
uniform
gamma

9. Electricity
demand
• Electricity
demand
follows
three
paierns:
• Yearly:
demand
is
greater
in
winter
• Weekly:
demand
is
lower
on
week-­‐ends
• Daily:
demand
peaks
in
the
evening
• For
ease
of
calculaCon,
we
fit
a
uniform
distribuCon
• Parameters
are
chosen
to
match
the
mean
and
standard
deviaFon
of
electricity
demand
Name
Value
(GW)
Dmin
33
Dmax
78
Mean
55.5
Standard
deviaFon
13

10. Optimal
nuclear
capacity
–
cost
minimization
• The
total
cost
of
producing
electricity
is:
• The
opFmal
capacity
saFsfies:
!
!
!

11. Optimal
nuclear
capacity
–
pro?it
maximization
• The
nuclear
monopoly
profit
is
given
by:
!
• The
profit-­‐maximizing
capacity
is
given
by:
!
• This
is
the
same
expression
as
before!

12. Optimal
nuclear
capacity
!
• The
capacity
that
maximizes
total
welfare
also
maximizes
the
profit
of
the
nuclear
monopoly.
Indeed:
• R
is
the
total
payment
from
consumers
to
producers.
The
price
of
electricity
is
P
regardless
of
its
source,
so
R
is
a
constant.
• Hence,
maximizing
monopoly
profit
is
equivalent
to
minimizing
total
cost.

13. Model
calibration
• We
calibrate
our
model
so
that
K*
=
63
GW,
the
total
nuclear
capacity
currently
installed
in
France.
• Senng
b
=
1
(numéraire
price),
we
obtain
P
–
c
=
3,
and
Π(K*)
=
96.
-­‐60
-­‐40
-­‐20
0
20
40
60
80
100
120
0
10
20
30
40
50
60
70
80
90
100
Monopoly
profit
Monopoly
capacity
(GW)

14. Duopoly
• We
now
introduce
a
second
firm
in
the
nuclear
market.
• Firm
1,
the
incumbent,
has
capacity
k1
=
63
GW
• Firm
2,
the
entrant,
has
capacity
k2
<
k1
• Both
firms
have
marginal
cost
c
and
investment
cost
b
• The
firms
compete
via
a
centralized
aucFon
mechanism
described
in
Fabra,
von
der
Fehr,
and
Harbord
(2006)
• We
denote
demand
by
D
and
let
θ
=
min(D,
K).
• θ
is
allocated
to
the
two
nuclear
producers
• If
D
>
K,
the
excess
is
dispatched
to
convenFonal
producers

15. Auction
mechanism
• Each
firm
submits
a
bid
pi
.
We
let
p
=
(p1,
p2).
• Output
allocated
to
supplier
i
is
denoted
by
qi(θ,
p)
!
• The
lower-­‐bidding
firm
dispatches
all
its
capacity
• If
demand
exceeds
this
capacity,
then
the
higher-­‐bidding
firm
serves
residual
demand.
• Discriminatory
aucFon:
an
acFve
supplier
receives
its
offer
price,
so
profits
are
given
by:
!

16. Equilibria

17. Large
?irm
pro?it
• Firm
1
operaFng
profit
is
given
by:
!
• With
fixed
k1,
firm
1
profit
is
a
decreasing
funcFon
of
k2
that
is:
• QuadraFc
when
k2
<
Dmin
• Linear
when
k2
≥
Dmin
• Firm
1’s
opFmal
choice
of
capacity
is:
!

18. Small
?irm
pro?it
• Firm
2
operaFng
profit
is
given
by:
!
• With
fixed
k1,
firm
2
profit
is
a
conFnuous
funcFon
of
k2
.
• It
is
cubic
when
k2
<
Dmin
• When
k2
≥
Dmin,
the
expression
involves
log(k2)
and
powers
of
k2
• The
opFmal
capacity
for
firm
2
is
given
by
• When
k2
<
Dmin,
k2*
is
the
soluFon
to
a
quadraFc
equaFon.
• When
k2
≥
Dmin,
the
equaFon
must
be
solved
numerically.
!

19. Duopoly:
individual
pro?its
-­‐20
0
20
40
60
80
100
120
0
5
10
15
20
25
30
35
Profit
(aXer
investment
costs)
Firm
2
capacity
(GW)
Firm
1
Firm
2
• Firm
2
chooses
capacity
k2*
=
17.5
GW
and
makes
profit
19.
• Firm
1
profit
is
then
reduced
by
about
50%
(from
96
to
51).
• Note:
any
capacity
below
Dmin
is
profitable
for
firm
2.

20. Duopoly:
total
pro?it,
cost,
and
revenue
-­‐20
0
20
40
60
80
100
120
140
160
180
0
5
10
15
20
25
30
35
Capacity
of
firm
2
(GW)
total
profit
total
cost
total
revenue
• Entry
by
firm
2
leads
to
excess
capacity,
driving
up
total
cost
• Total
profit
falls:
firm
2
profit
does
not
compensate
profit
lost
by
firm
1
• Net
price
(P
–
c)
is
proporFonal
to
total
revenue:
it
falls
by
10%
when
k2
=
k2*

21. Introducing
contracts
• We
introduce
long-­‐term
contracts
in
the
following
manner:
1. Firm
1
has
a
monopoly
and
chooses
a
volume
f
of
long-­‐term
contracts.
2. Firm
2
observes
these
contracts
and
builds
capacity
k2*(
f
).
3. The
two
firms
compete
on
the
spot
market.
• The
contracts
sFpulate
that
firm
1
supplies
power
to
customers
at
a
constant
level
f
for
price
pf
=
P.
• The
contracts
are
“long
term”
in
the
sense
that
they
are
sFll
in
effect
when
firm
2
enters
the
market.
• The
size
of
the
spot
market
is
reduced
by
f:
• Dmin’
=
Dmin
–
f
• Dmax’
=
Dmax
–
f
• k1’
=
k1
–
f

22. Contracts:
?irm
2
capacity
0
5
10
15
20
25
30
35
0
5
10
15
20
25
30
35
Capacity
(GW)
Volume
of
contracts
held
by
firm
1
(GW)
k2
Dmin
-­‐
f
• Capacity
chosen
by
firm
2
is
strictly
decreasing
in
f
• The
reducFon
in
k2
is
approximately
proporFonal
to
f
/
k1
• There
is
a
change
in
slope
when
f
>
23.7
GW:
then
k2*(
f
)
>
Dmin’

23. Contracts:
individual
pro?its
0
10
20
30
40
50
60
70
80
90
0
5
10
15
20
25
30
35
Profits
(aXer
investment
costs)
Volume
of
contracts
held
by
firm
1
Firm
1
Firm
2
• Firm
1
profit
is
strictly
increasing
in
f
but
remains
below
monopoly
level
• Firm
2
profit
is
strictly
decreasing
in
f
but
remains
above
zero
à
Firm
1
cannot
exclude
firm
2
completely
unless
there
are
large
fixed
costs

24. Contracts:
total
pro?it
and
total
cost
65
70
75
80
85
90
0
5
10
15
20
25
30
35
Volume
of
contracts
held
by
firm
1
(GW)
Total
profit
Total
cost
• Total
profit
is
increasing
in
f
but
remains
below
monopoly
level
• Total
cost
is
decreasing
in
f
as
excess
capacity
is
reduced

25. Contracts:
total
revenue
50
70
90
110
130
150
170
0
5
10
15
20
25
30
35
Total
revenue
Volume
of
contracts
held
by
firm
1
(GW)
Including
contracts
Excluding
contracts
• Total
revenue,
including
revenue
from
contracts,
is
increasing
in
f
• Total
revenue
excluding
contracts
(spot
market
revenue)
is
decreasing
in
f
as
the
size
of
the
spot
market
is
reduced.

26. Contracts:
spot
market
price
• We
define
an
index
of
the
spot
market
price:
!
2.68
2.685
2.69
2.695
2.7
2.705
2.71
2.715
2.72
2.725
0
5
10
15
20
25
30
35
Spot
market
price
index
Volume
of
contracts
held
by
firm
1
(GW)
• Pavg
=
spot
market
revenue
/
spot
market
size
• Both
quanFFes
are
decreasing
with
f,
so
the
effect
of
long-­‐term
contracts
on
spot
market
price
is
ambiguous
• Changes
in
price
are
very
small:
it
remains
within
1%
of
its
value
with
free
entry

27. Conclusion
• In
the
absence
of
contracts,
market
entry
leads
to
excess
nuclear
capacity.
• Total
cost
increases
• Total
profit
decreases
• Price
decreases
• Long-­‐term
contracts
reduce
entry
but
cannot
eliminate
it
enFrely
(unless
the
rival
has
large
fixed
costs).
• Incumbent
can
increase
profit
but
cannot
recover
monopoly
profit
• The
price
of
electricity
on
the
spot
market
is
not
significantly
affected
by
contracts
• It
remains
at
the
free
entry
level
• Extensions:
• IncenFves
• RegulaFon

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as
a
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29. Questions?